unit 2 : accounting concepts, principles and … · accounting information. accounting conventions...

1.22 PRINCIPLES AND PRACTICE OF ACCOUNTING

After studying this unit, you will be able to :

w Grasp the basic accounting concepts, principles and conventions and observe their implications while

recording transactions and events.

w Identify the three fundamental accounting assumptions:

ª Going Concern

ª Consistency

ª Accrual

w Understand the qualitative characteristics that will help to develop the skill in course of time to prepare

�nancial statements.

UNIT 2 : ACCOUNTING CONCEPTS, PRINCIPLES AND CONVENTIONS

LEARNING OUTCOMES

© The Institute of Chartered Accountants of India

1.23THEORETICAL FRAMEWORK

2.1 INTRODUCTIONLet us imagine a situation where you are a proprietor and you take copies of your books of account to �ve di�erent accountants. You ask them to prepare the �nancial statements on the basis of the above records and to calculate the pro�ts of the business for the year. After few days, they are ready with the �nancial statements and all the �ve accountants have calculated �ve di�erent amounts of pro�ts and that too with very wide variations among them. Guess in such a situation what impact would it leave on you about accounting profession. To avoid this, a generally accepted set of rules have been developed. This generally accepted set of rules provides unity of understanding and unity of approach in the practice of accounting and also in better preparation and presentation of the �nancial statements.

Accounting is a language of the business. Financial statements prepared by the accountant communicate �nancial information to the various stakeholders for decision-making purpose. Therefore, it is important that �nancial statements prepared by di�erent organizations should be prepared on uniform basis. Also there should be consistency over a period of time in the preparation of these �nancial statements. If every accountant starts following his own norms and notions for accounting of di�erent items then there will be an utter confusion.

Money measurement concept

Entity concept

Cost concept

Periodicity concept

Realisation concept

Accrual concept

Dual aspect concept

Matching concept

Conservatism

Going Concern concept

Consistency

Materiality

Conc

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, Pri

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Con

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UNIT OVERVIEW



To avoid confusion and to achieve uniformity, accounting process is applied within the conceptual framework of ‘Generally Accepted Accounting Principles’ (GAAPs). The term GAAPs is used to describe rules developed for the preparation of the �nancial statements and are called concepts, conventions, postulates, principles etc. These GAAPs are the backbone of the accounting information system, without which the whole system cannot even stand erectly. These principles are the ground rules, which de�ne the parameters and constraints within which accounting reports are generated. Accounting principles are basic norms and assumptions on which the whole accounting system has been developed and established. Accountant also adheres to various accounting standards issued by the regulatory authority for the standardization of accounting policies to be followed under speci�c circumstances. These conceptual frameworks, GAAPs and accounting standards are considered as the theory base of accounting.

2.2 ACCOUNTING CONCEPTSAccounting concepts de�ne the assumptions on the basis of which �nancial statements of a business entity are prepared. Certain concepts are perceived, assumed and accepted in accounting to provide a unifying structure and internal logic to accounting process. The word concept means idea or notion, which has universal application. Financial transactions are interpreted in the light of the concepts, which govern accounting methods. Concepts are those basic assumptions and conditions, which form the basis upon which the accountancy has been laid. Unlike physical science, accounting concepts are only result of broad consensus. These accounting concepts lay the foundation on the basis of which the accounting principles are formulated.

2.3 ACCOUNTING PRINCIPLES“Accounting principles are a body of doctrines commonly associated with the theory and procedures of accounting serving as an explanation of current practices and as a guide for selection of conventions or procedures where alternatives exist.”

Accounting principles must satisfy the following conditions:

1. They should be based on real assumptions;

2. They must be simple, understandable and explanatory;

3. They must be followed consistently;

4. They should be able to re�ect future predictions;

5. They should be informational for the users.

2.4 ACCOUNTING CONVENTIONSAccounting conventions emerge out of accounting practices, commonly known as accounting principles, adopted by various organizations over a period of time. These conventions are derived by usage and practice. The accountancy bodies of the world may change any of the convention to improve the quality of accounting information. Accounting conventions need not have universal application.

In the study material, the terms ‘accounting concepts’, ‘accounting principles’ and ‘accounting conventions’ have been used interchangeably to mean those basic points of agreement on which �nancial accounting theory and practice are founded.



2.5 CONCEPTS, PRINCIPLES AND CONVENTIONS - AN OVERVIEWNow we shall study in detail the various accounting concepts on which accounting is based. The following are the widely accepted accounting concepts:

(a) Entity concept: Entity concept states that business enterprise is a separate identity apart from its owner. Accountants should treat a business as distinct from its owner. Business transactions are recorded in the business books of accounts and owner’s transactions in his personal books of accounts. The practice of distinguishing the a�airs of the business from the personal a�airs of the owners originated only in the early days of the double-entry book-keeping. This concept helps in keeping business a�airs free from the in�uence of the personal a�airs of the owner. This basic concept is applied to all the organizations whether sole proprietorship or partnership or corporate entities.

Entity concept means that the enterprise is liable to the owner for capital investment made by the owner. Since the owner invested capital, which is also called risk capital, he has claim on the pro�t of the enterprise. A portion of pro�t which is apportioned to the owner and is immediately payable becomes current liability in the case of corporate entities.

Example: Mr. X started business investing ̀ 7,00,000 with which he purchased machinery for ̀ 5,00,000 and maintained the balance in hand. The �nancial position of the will be as follows:

`

Capital 7,00,000 Machinery 5,00,000Cash 2,00,000

This means that the enterprise owes to Mr. X ` 7,00,000. Now if Mr. X spends ` 5,000 to meet his family expenses from the business fund, then it should not be taken as business expenses and would be charged to his capital account (i.e., his investment would be reduced by ` 5,000). Following the entity concept the revised �nancial position would be

Liability ` `

Capital 7,00,000 Less : Drawings (5,000) 6,95,000Machinery 5,00,000Cash 1,95,000

(b) Money measurement concept: As per this concept, only those transactions, which can be measured in terms of money are recorded. Since money is the medium of exchange and the standard of economic value, this concept requires that those transactions alone that are capable of being measured in terms of money be only to be recorded in the books of accounts. Transactions, even if, they a�ect the results of the business materially, are not recorded if they are not convertible in monetary terms. Transactions and events that cannot be expressed in terms of money are not recorded in the business books. For example; employees of the organization are, no doubt, the assets of the organizations but their measurement in monetary terms is not possible therefore, not included in the books of account of the organization. Measuring unit for money is taken as the currency of the ruling country i.e., the ruling currency of a country provides a common denomination for the value of material objects. The monetary unit though an inelastic yardstick, remains indispensable tool of accounting.

It may be mentioned that when transactions occur across the boundary of a country, one may see many currencies. Suppose a businessman sells goods worth ` 50 lakhs at home and he also sells goods worth



of 1 lakh Euro in the United States. What is his total sales? ` 50 lakhs plus 1 lakh Euro.

These are not amenable to even arithmetic treatment. So transactions are to be recorded at uniform monetary unit i.e. in one currency. Suppose EURO 1 = ` 71.

Total Sales = ` 50 lakhs plus 71 lakhs = ` 121 lakhs. Money Measurement Concept imparts the essential �exibility for measurement and interpretation of accounting data.

This concept ignores that money is an inelastic yardstick for measurement as it is based on the implicit assumption that purchasing power of the money is not of su�cient importance as to require adjustment. Also, many material transactions and events are not recorded in the books of accounts just because theycannot be measured in monetary terms. Therefore it is recognized by all the accountants that this concept has its own limitations and inadequacies. Yet it is used for accounting purposes because it is not possible to adopt a better measurement scale.

Entity and money measurement are viewed as the basic concepts on which other procedural concepts hinge.

(c) Periodicity concept: This is also called the concept of de�nite accounting period. As per ‘going concern’ concept an inde�nite life of the entity is assumed. For a business entity it causes inconvenience to measure performance achieved by the entity in the ordinary course of business.

If a textile mill lasts for 100 years, it is not desirable to measure its performance as well as �nancial position only at the end of its life.

So a small but workable fraction of time is chosen out of in�nite life cycle of the business entity for measuring performance and looking at the �nancial position. Generally one year period is taken up for performance measurement and appraisal of �nancial position. However, it may also be 6 months or 9 months or 15 months.

According to this concept accounts should be prepared after every period & not at the end of the life of the entity. Usually this period is one calendar year. We generally follow from 1st April of a year to 31st March of the immediately following year.

Thus, for performance appraisal it is not necessary to look into the revenue and expenses of an unduly long time-frame. This concept makes the accounting system workable and the term ‘accrual’ meaningful. If one thinks of inde�nite time-frame, nothing will accrue. There cannot be unpaid expenses and non-receipt of revenue. Accrued expenses or accrued revenue is only with reference to a �nite time-frame which is called accounting period.

Thus, the periodicity concept facilitates in:

(i) Comparing of �nancial statements of di�erent periods

(ii) Uniform and consistent accounting treatment for ascertaining the pro�t and assets of the business

(iii) Matching periodic revenues with expenses for getting correct results of the business operations

(d) Accrual concept: Under accrual concept, the e�ects of transactions and other events are recognised on mercantile basis i.e., when they occur (and not as cash or a cash equivalent is received or paid) and they are recorded in the accounting records and reported in the �nancial statements of the periods to which they relate. Financial statements prepared on the accrual basis inform users not only of past events involving the payment and receipt of cash but also of obligations to pay cash in the future and of resources that represent cash to be received in the future.

To understand accrual assumption knowledge of revenues and expenses is required. Revenue is the gross in�ow of cash, receivables and other consideration arising in the course of the ordinary activities



of an enterprise from sale of goods, from rendering services and from the use by others of enterprise’s resources yielding interest, royalties and dividends. For example, (1) Mr. X started a cloth merchandising. He invested ` 50,000, bought merchandise worth ` 50,000. He sold such merchandise for ` 60,000. Customers paid him ` 50,000 cash and assure him to pay ` 10,000 shortly. His revenue is ` 60,000. It arose in the ordinary course of cloth business; Mr. X received ` 50,000 in cash and ` 10,000 by way of receivables.

Take another example; (2) an electricity supply undertaking supplies electricity spending ` 16,00,000 for fuel and wages and collects electricity bill in one month ` 20,00,000 by way of electricity charges. This is also revenue which arose from rendering services.

Lastly, (3) Mr. A invested ` 1,00,000 in a business. He purchased a machine paying ` 1,00,000. He hired it out for ` 20,000 annually to Mr. B. ` 20,000 is the revenue of Mr. A; it arose from the use by others of the enterprise’s resources.

Expense is a cost relating to the operations of an accounting period or to the revenue earned during the period or the bene�ts of which do not extend beyond that period.

In the �rst example, Mr. X spent ̀ 50,000 to buy the merchandise; it is the expense of generating revenue of ` 60,000. In the second instance ` 16,00,000 are the expenses. Also whenever any asset is used it has a �nite life to generate bene�t. Suppose, the machine purchased by Mr. A in the third example will last for 10 years only. Then ` 10,000 is the expense every year relating to the cost of machinery. For the time being, ignore the idea of accounting period.

Accrual means recognition of revenue and costs as they are earned or incurred and not as money is received or paid. The accrual concept relates to measurement of income, identifying assets and liabilities.

Example: Mr. J D buys clothing of ̀ 50,000 paying cash ̀ 20,000 and sells at ̀ 60,000 of which customers paid only ` 50,000.

His revenue is ` 60,000, not ` 50,000 cash received. Expense (i.e., cost incurred for the revenue) is ` 50,000, not ` 20,000 cash paid. So the accrual concept based pro�t is ` 10,000 (Revenue – Expenses).

As per Accrual Concept : Revenue – Expenses = Pro�t

Accrual Concept provides the foundation on which the structure of present day accounting has been developed.

Alternative as per Cash basis

Cash received in ordinary course of business – Cash paid in ordinary course of business = pro�t.

Revenue may not be realised in cash. Cash may be received simultaneously or

(i) before revenue is created (A. 1)

(ii) after revenue is created (A. 2)

Expenses may not be paid in cash. Cash may be paid simultaneously or

(i) before expense is made (B. 1) (ii) after expense is made (B. 2)

A. 1 creates a liability when cash is received in advance. A. 2 creates an asset called Trade receivables.B.1 creates an asset called Trade Advance when cash is paid in advance while B. 2 creates a liability called payables or Trade payables or outstanding liabilities. If the expenses remain unpaid in respect of goods, it is called Trade payables, if it remains unpaid for other expenses, it is called Expense payables.



(e) Matching concept: In this concept, all expenses matched with the revenue of that period should only be taken into consideration. In the �nancial statements of the organization if any revenue is recognized then expenses related to earn that revenue should also be recognized.

This concept is based on accrual concept as it considers the occurrence of expenses and income and do not concentrate on actual in�ow or out�ow of cash. This leads to adjustment of certain items like prepaid and outstanding expenses, unearned or accrued incomes.

It is not necessary that every expense identify every income. Some expenses are directly related to the revenue and some are time bound. For example:- selling expenses are directly related to sales but rent, salaries etc are recorded on accrual basis for a particular accounting period. In other words periodicity concept has also been followed while applying matching concept.

Mr. P K started cloth business. He purchased 10,000 pcs. garments @ ` 100 per piece and sold 8,000 pcs. @ ` 150 per piece during the accounting period of 12 months 1st January to 31st December, 2015. He paid shop rent @ ` 3,000 per month for 11 months and paid ` 8,00,000 to the suppliers of garments and received ` 10,00,000 from the customers.

Let us see how the accrual and periodicity concepts operate.

Periodicity Concept �xes up the time-frame for which the performance is to be measured and �nancial position is to be appraised. Here, it is January 2015 - December, 2015. So revenues and expenses are to be measured for the year 2015 and assets and liabilities are to be ascertained as on 31st December, 2015.

Accrual Concept operates to measure revenue of ` 12,00,000 (arising out of sale of garments 8,000 Pcs × ` 150) which accrued during 2015, not the cash received ` 10,00,000 and also the expenses correctly. Shop rent for 12 months is an expense item amounting to ` 36,000, not ` 33,000 the cash paid.

Should the accountant treat ` 10,00,000 as expenses for purchase of merchandise ? And should he treat ` 1,64,000 as pro�t? (Revenue ` 12,00,000-Merchandise ` 10,00,000. Shop Rent ` 36,000). Obviously the answer is No. Matching links revenue with expenses.

Revenue – Expenses = Pro�t

But this unquali�ed equation may create misconception. It should be de�ned as :

Periodic Pro�t = Periodic Revenue – Matched Expenses

From the revenue of an accounting period such expenses are deducted which are expended to generate the revenue to determine pro�t of that period.

In the given example revenue relates to only sale of 8,000 pcs. of garments. So the cost of 8,000 pcs of garments should be treated as expenses.

Thus, Pro�t = Revenue ` 12,00,000 Less: Expenses: Merchandise ` 8,00,000 Shop Rent ` 36,000 (` 8,36,000)

` 3,64,000Assets: Inventory (2,000 pcs × ` 100) ` 2,00,000 Trade receivables ` 2,00,000



Cash (Cash Receipts ` 10,00,000 – cash payments ` 8,33,000)

` 1,67,000

` 5,67,000Liabilities: Trade Payables ` 2,00,000 Expense Payables ` 3,000 Capital (for Pro�t) ` 3,64,000

` 5,67,000

Thus, accrual, matching and periodicity concepts work together for income measurement and recognition of assets and liabilities.

(f) Going Concern concept: The �nancial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the �nancial statements may have to be prepared on a di�erent basis and, if so, the basis used is disclosed.

The valuation of assets of a business entity is dependent on this assumption. Traditionally, accountants follow historical cost in majority of the cases.

Suppose Mr. X purchased a machine for his business paying ` 5,00,000 out of ` 7,00,000 invested by him. He also paid transportation expenses and installation charges amounting to ` 70,000. If he is still willing to continue the business, his �nancial position will be as follows:

Balance Sheet

Liability ` Assets `

Capital 7,00,000 Machinery 5,70,000

Cash 1,30,000

7,00,000 7,00,000

Now if he decides to back out and desires to sell the machine, it may fetch more than or less than ` 5,70,000. So his �nancial position should be di�erent. If going concern concept is taken, increase/decrease in the value of assets in the short-run is ignored. The concept indicates that assets are kept for generating bene�t in future, not for immediate sale; current change in the asset value is not realisable and so it should not be counted.

(g) Cost concept: By this concept, the value of an asset is to be determined on the basis of historical cost, in other words, acquisition cost. Although there are various measurement bases, accountants traditionally prefer this concept in the interests of objectivity. When a machine is acquired by paying ` 5,00,000, following cost concept the value of the machine is taken as ` 5,00,000. It is highly objective and free from all bias. Other measurement bases are not so objective. Current cost of an asset is not easily determinable. If the asset is purchased on 1.1.1995 and such model is not available in the market, it becomes di�cult to determine which model is the appropriate equivalent to the existing one. Similarly, unless the machine is actually sold, realisable value will give only a hypothetical �gure. Lastly, present value base is highly subjective because to know the value of the asset one has to chase the uncertain future.



However, the cost concept creates a lot of distortion too as outlined below :

(a) In an in�ationary situation when prices of all commodities go up on an average, acquisition cost loses its relevance. For example, a piece of land purchased on 1.1.1995 for ` 2,000 may cost ` 1,00,000 as on 1.1.2015. So if the accountant makes valuation of asset at historical cost, the accounts will not re�ect the true position.

(b) Historical cost-based accounts may lose comparability. Mr. X invested ` 1,00,000 in a machine on 1.1.1995 which produces ` 50,000 cash in�ow during the year 2015, while Mr. Y invested ` 5,00,000 in a machine on 1.1.2005 which produced ` 50,000 cash in�ows during the year. Mr. X earned at the rate 50% while Mr. Y earned at the rate 10%. Who is more e�cient? Since the assets are recorded at the historical cost, the results are not comparable. Obviously it is a corollary to (a).

(c) Many assets do not have acquisition costs. Human assets of an enterprise are an example. The cost concept fails to recognise such asset although it is a very important asset of any organization.

Many other controversial issues have arisen in �nancial accounting that revolves around the cost concept which will be discussed at the advanced stage. However, later on we shall see that in many circumstances, the cost convention is not followed. See conservatism concept for an example, which will be discussed later on in this unit.

(h) Realisation concept: It closely follows the cost concept. Any change in value of an asset is to be recorded only when the business realises it. When an asset is recorded at its historical cost of ` 5,00,000 and even if its current cost is ` 15,00,000 such change is not counted unless there is certainty that such change will materialize.

However, accountants follow a more conservative path. They try to cover all probable losses but do not count any probable gain. That is to say, if accountants anticipate decrease in value they count it, but if there is increase in value they ignore it until it is realised. Economists are highly critical about the realisation concept. According to them, this concept creates value distortion and makes accounting meaningless.

Example: Mr. X purchased a piece of land on 1.1.1995 paying `2,000. Its current market value is ` 1,02,000 on 31.12.2015. Should the accountant show the land at `2,000 following cost concept and ignoring `1,00,000 value increase since it is not realised? If he does so, the �nancial position would be:

Balance Sheet

Liability ` Asset `

Capital 2,000 Land 2,000 2,000 2,000

Is it not proper to show it in the following manner?Balance Sheet

Liabilities ` Asset `

Capital 2,000 Land 1,02,000Unrealised Gain 1,00,000

1,02,000 1,02,000



Now-a-days the revaluation of assets has become a widely accepted practice when the change in value is of permanent nature. Accountants adjust such value change through creation of revaluation (capital) reserve.

Thus the going concern, cost concept and realization concept gives the valuation criteria.

(i) Dual aspect concept: This concept is the core of double entry book-keeping. Every transaction or event has two aspects:

(1) It increases one Asset and decreases other Asset;

(2) It increases an Asset and simultaneously increases Liability;

(3) It decreases one Asset, increases another Asset;

(4) It decreases one Asset, decreases a Liability.

Alternatively:

(5) It increases one Liability, decreases other Liability;

(6) It increases a Liability, increases an Asset;

(7) It decreases Liability, increases other Liability;

(8) It decreases Liability, decreases an Asset.

Example:Balance Sheet

Liabilities ` Assets `


Bank Loan 75,000 Cash 1,00,000

Other Loan 75,000

3,00,000 3,00,000

Transactions:

(a) A new machine is purchased paying ` 50,000 in cash.

(b) A new machine is purchased for ` 50,000 on credit, cash is to be paid later on.

(c) Cash paid to repay bank loan to the extent of ` 50,000.

(d) Raised bank loan of ` 50,000 to pay o� other loan.

E�ect of the Transactions:

(a) Increase in machine value and decrease in cash balance by ` 50,000.



Balance Sheet (1 & 3)



Bank Loan 75,000 Cash 50,000

Other Loan 75,000

3,00,000 3,00,000

(b) Increase in machine value and increase in Creditors by ` 50,000.




Creditors for machinery 50,000 Cash 1,00,000

Bank Loan 75,000

Other Loan 75,000

3,50,000 3,50,000

(c) Decrease in bank loan and decrease in cash by ` 50,000.




Bank Loan 25,000 Cash 50,000

Other Loan 75,000

2,50,000 2,50,000

(d) Increase in bank loan and decrease in other loan by ` 50,000.




Bank Loan 1,25,000 Cash 1,00,000

Other Loan 25,000

3,00,000 3,00,000



So every transaction and event has two aspects.

This gives basic accounting equation :

Equity (E) + Liabilities (L) = Assets (A)

or

Equity (E)= Assets (A) – Liabilities(L)

Or, Equity + Long Term Liabilities + Current Liabilities = Fixed Assets + Current Assets

Or, Equity + Long Term Liabilities = Fixed Assets + (Current Assets – Current Liabilities)

Or, Equity = Fixed Assets + Working Capital – Long Term Liabilities

? ILLUSTRATION

Develop the accounting equation from the following information: -

Particulars April 1, 2016 (`)

March 31, 2017 (`)

Capital 1,00,000 ?

12% Bank Loan 1,00,000 1,00,000

Trade Payables 75,000 70,000

Fixed Assets 1,25,000 1,10,000

Trade Receivables 75,000 80,000

Inventory 70,000 80,000

Cash & Bank 5,000 6,000

Required

Find the pro�t for the year & the Balance sheet as on 31/3/2017.

SOLUTION

For the year ended April 1, 2016:

Equity = Capital ` 1,00,000

Liabilities = Bank Loan + Trade Payables

` 1,00,000 + ` 75,000 = ` 1,75,000

Assets = Fixed Assets + Trade Receivables + Inventory + Cash & Bank

` 1,25,000 + ` 75,000 + ` 70,000 + ` 5,000 = ` 2,75,000

Equity + Liabilities = Assets

` 1,00,000 + ` 1,75,000 = 2,75,000



For the year ended April 1, 2017:

Assets = ` 1,10,000 + ` 80,000 + ` 80,000 + ` 6,000 = ` 2,76,000

Liabilities = ` 1,00,000 + ` 70,000 = ` 1,70,000

Equity = Assets – Liabilities = ` 2,76,000 – ` 1,70,000 = ` 1,06,000

Pro�ts = New Equity – Old Equity = ` 1,06,000 – `1,00,000 = ` 6,000

(j) Conservatism: Conservatism states that the accountant should not anticipate income and should provide for all possible losses. When there are many alternative values of an asset, an accountant should choose the method which leads to the lesser value. Later on we shall see that the golden rule of current assets valuation - ‘cost or market price whichever is lower’ originated from this concept.

The Realisation Concept also states that no change should be counted unless it has materialised. The Conservatism Concept puts a further brake on it. It is not prudent to count unrealised gain but it is desirable to guard against all possible losses.

For this concept there should be at least three qualitative characteristics of �nancial statements, namely,

(i) Prudence, i.e., judgement about the possible future losses which are to be guarded, as well as gains which are uncertain.

(ii) Neutrality, i.e., unbiased outlook is required to identify and record such possible losses, as well as to exclude uncertain gains,

(iii) Faithful representation of alternative values.

Many accounting authors, however, are of the view that conservatism essentially leads to understatement of income and wealth and it should not be the basis for the preparation of �nancial statements.

(k) Consistency: In order to achieve comparability of the �nancial statements of an enterprise through time, the accounting policies are followed consistently from one period to another; a change in an accounting policy is made only in certain exceptional circumstances.

The concept of consistency is applied particularly when alternative methods of accounting are equally acceptable. For example a company may adopt any of several methods of depreciation such as written-down-value method, straight-line method, etc. Likewise there are many methods for valuation of inventories. But following the principle of consistency it is advisable that the company should follow consistently over years the same method of depreciation or the same method of valuation of Inventories which is chosen. However in some cases though there is no inconsistency, they may seem to be inconsistent apparently. In case of valuation of Inventories if the company applies the principle ‘at cost or market price whichever is lower’ and if this principle accordingly results in the valuation of Inventories in one year at cost price and the market price in the other year, there is no inconsistency here. It is only an application of the principle.

But the concept of consistency does not imply non-�exibility as not to allow the introduction of improved method of accounting.

An enterprise should change its accounting policy in any of the following circumstances only:

a. To bring the books of accounts in accordance with the issued Accounting Standards.

b. To comply with the provision of law.

c. When under changed circumstances it is felt that new method will re�ect more true and fair picture



in the �nancial statement.

(l) Materiality: Materiality principle permits other concepts to be ignored, if the e�ect is not considered material. This principle is an exception to full disclosure principle. According to materiality principle, all the items having signi�cant economic e�ect on the business of the enterprise should be disclosed in the �nancial statements and any insigni�cant item which will only increase the work of the accountant but will not be relevant to the users’ need should not be disclosed in the �nancial statements.

The term materiality is the subjective term. It is on the judgement, common sense and discretion of the accountant that which item is material and which is not. For example stationary purchased by the organization though not used fully in the accounting year purchased still shown as an expense of that year because of the materiality concept. Similarly depreciation on small items like books, calculators etc. is taken as 100% in the year of purchase though used by the entity for more than a year. This is because the amount of books or calculator is very small to be shown in the balance sheet though it is the asset of the company.

The materiality depends not only upon the amount of the item but also upon the size of the business, nature and level of information, level of the person making the decision etc. Moreover an item material to one person may be immaterial to another person. What is important is that omission of any information should not impair the decision-making of various users.

2.6 FUNDAMENTAL ACCOUNTING ASSUMPTIONSThere are three fundamental accounting assumptions :

(i) Going Concern

(ii) Consistency

(iii) Accrual

All the above three fundamental accounting assumptions have already been explained in this para 2.5.

If nothing has been written about the fundamental accounting assumption in the �nancial statements then it is assumed that they have already been followed in their preparation of �nancial statements. However, if any of the above mentioned fundamental accounting assumption is not followed then this fact should be speci�cally disclosed.

2.7 FINANCIAL STATEMENTSThe aim of accounting is to keep systematic records to ascertain �nancial performance and �nancial position of an entity and to communicate the relevant �nancial information to the interested user groups. The �nancial statements are basic means through which the management of an entity makes public communication of the �nancial information along with selected quantitative details. They are structured �nancial representations of the �nancial position and the performance of an enterprise. To have a record of all business transactions and also to determine whether all these transactions resulted in either ‘pro�t or loss’ for the period, all the entities will prepare �nancial statements viz., balance sheet, pro�t and loss account, cash �ow statement etc. by following various accounting concepts, principles, and conventions which have been already discussed in detail.



2.7.1 Qualitative Characteristics of Financial Statements

Qualitative characteristics are the attributes that make the information provided in �nancial statements useful to users. The following are the important qualitative characteristics of the �nancial statements:

1. Understandability: An essential quality of the information provided in �nancial statements is that it must be readily understandable by users. For this purpose, it is assumed that users have a reasonable knowledge of business and economic activities and accounting and study the information with reasonable diligence. Information about complex matters that should be included in the �nancial statements because of its relevance to the economic decision-making needs of users should not be excluded merely on the ground that it may be too di�cult for certain users to understand.

2. Relevance: To be useful, information must be relevant to the decision-making needs of users. Information has the quality of relevance when it in�uences the economic decisions of users by helping them evaluate past, present or future events or con�rming, or correcting, their past evaluations.

The predictive and con�rmatory roles of information are interrelated. For example, information about the current level and structure of asset holdings has value to users when they endeavour to predict the ability of the enterprise to take advantage of opportunities and its ability to react to adverse situations. The same information plays a con�rmatory role in respect of past predictions about, for example, the way in which the enterprise would be structured or the outcome of planned operations.

Information about �nancial position and past performance is frequently used as the basis for predicting future �nancial position and performance and other matters in which users are directly interested, such as dividend and wage payments, share price movements and the ability of the enterprise to meet its commitments as they fall due. To have predictive value, information need not be in the form of an explicit forecast. The ability to make predictions from �nancial statements is enhanced, however, by the manner in which information on past transactions and events is displayed. For example, the predictive value of the statement of pro�t and loss is enhanced if unusual, abnormal and infrequent items of income and expense are separately disclosed.

3. Reliability: To be useful, information must also be reliable, Information has the quality of reliability when it is free from material error and bias and can be depended upon by users to represent faithfully that which it either purports to represent or could reasonably be expected to represent.

Information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading. For example, if the validity and amount of a claim for damages under a legal action against the enterprise are highly uncertain, it may be inappropriate for the enterprise to recognise the amount of the claim in the balance sheet, although it may be appropriate to disclose the amount and circumstances of the claim.

4. Comparability: Users must be able to compare the �nancial statements of an enterprise through time in order to identify trends in its �nancial position, performance and cash �ows. Users must also be able to compare the �nancial statements of di�erent enterprises in order to evaluate their relative �nancial position, performance and cash �ows. Hence, the measurement and display of the �nancial e�ects of like transactions and other events must be carried out in a consistent way throughout an enterprise and over time for that enterprise and in a consistent way for di�erent enterprises.

An important implication of the qualitative characteristic of comparability is that users be informed of the accounting policies employed in the preparation of the �nancial statements, any changes in those polices and the e�ects of such changes. Users need to be able to identify di�erences between the accounting policies for like transactions and other events used by the same enterprise from period to period and by di�erent enterprises. Compliance with Accounting Standards, including the disclosure of the accounting policies used by the enterprise, helps to achieve comparability.



The need for comparability should not be confused with mere uniformity and should not be allowed to become an impediment to the introduction of improved accounting standards. It is not appropriate for an enterprise to continue accounting in the same manner for a transaction or other event if the policy adopted is not in keeping with the qualitative characteristics of relevance and reliability. It is also inappropriate for an enterprise to leave its accounting policies unchanged when more relevant and reliable alternatives exist.

Users wish to compare the �nancial position, performance and cash �ows of an enterprise over time. Hence, it is important that the �nancial statements show corresponding information for the preceding period(s).

The four principal qualitative characteristics are understandability, relevance, reliability and comparability.

5. Materiality: The relevance of information is a�ected by its materiality. Information is material if its misstatement (i.e., omission or erroneous statement) could in�uence the economic decisions of users taken on the basis of the �nancial information. Materiality depends on the size and nature of the item or error, judged in the particular circumstances of its misstatement. Materiality provides a threshold or cut-o� point rather than being a primary qualitative characteristic which the information must have if it is to be useful.

4. Faithful Representation: To be reliable, information must represent faithfully the transactions and other events it either purports to represent or could reasonably be expected to represent. Thus, for example, a balance sheet should represent faithfully the transactions and other events that result in assets, liabilities and equity of the enterprise at the reporting date which meet the recognition criteria.

Most �nancial information is subject to some risk of being less than a faithful representation of that which it purports to portray. This is not due to bias, but rather to inherent di�culties either in identifying the transactions and other events to be measured or in devising and applying measurement and presentation techniques that can convey messages that correspond with those transactions and events. In certain cases, the measurement of the �nancial e�ects of items could be so uncertain that enterprises generally would not recognise them in the �nancial statements; for example, although most enterprises generate goodwill internally over time, it is usually di�cult to identify or measure that goodwill reliably. In other cases, however, it may be relevant to recognise items and to disclose the risk of error surrounding their recognition and measurement.

7. Substance Over Form: If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. The substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. For example, where rights and bene�cial interest in an immovable property are transferred but the documentations and legal formalities are pending, the recording of acquisition/disposal (by the transferee and transferor respectively) would in substance represent the transaction entered into.

8. Neutrality: To be reliable, the information contained in �nancial statements must be neutral, that is, free from bias. Financial statements are not neutral if, by the selection or presentation of information, they in�uence the making of a decision or judgement in order to achieve a predetermined result or outcome.

9. Prudence: The preparers of �nancial statements have to contend with the uncertainties that inevitably surround many events and circumstances, such as the collectability of receivables, the probable useful life of plant and machinery, and the warranty claims that may occur. Such uncertainties are recognised



by the disclosure of their nature and extent and by the exercise of prudence in the preparation of the �nancial statements. Prudence is the inclusion of a degree of caution in the exercise of the judgments needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses, because the �nancial statements would then not be neutral and, therefore, not have the quality of reliability.

10. Full, fair and adequate disclosure: The �nancial statement must disclose all the reliable and relevant information about the business enterprise to the management and also to their external users for which they are meant, which in turn will help them to take a reasonable and rational decision. For it, it is necessary that �nancial statements are prepared in conformity with generally accepted accounting principles i.e the information is accounted for and presented in accordance with its substance and economic reality and not merely with its legal form. The disclosure should be full and �nal so that users can correctly assess the �nancial position of the enterprise.

The principle of full disclosure implies that nothing should be omitted while principle of fair disclosure implies that all the transactions recorded should be accounted in a manner that �nancial statement purports true and fair view of the results of the business of the enterprise and adequate disclosure implies that the information in�uencing the decision of the users should be disclosed in detail and should make sense.

This principle is widely used in corporate organizations because of separation in management and ownership. The Companies Act in pursuant of this principle has came out with the format of balance sheet and pro�t and loss account. The disclosures of all the major accounting policies and other information are to be provided in the form of footnotes, annexures etc. The practice of appending notes to the �nancial statements is the outcome of this principle.

11. Completeness: To be reliable, the information in �nancial statements must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and de�cient in terms of its relevance.

Thus, if accounting information is to present faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality, not by their legal form. For example, if a business enterprise sells its assets to others but still uses the assets as usual for the purpose of the business by making some arrangement with the seller, it simply becomes a legal transaction. The economic reality is that the business is using the assets as usual for deriving the bene�t. Financial statement information should contain the substance of this transaction and should not only record going by legality. In order to be reliable the �nancial statements information should be neutral i.e., free from bias. The prepares of �nancial statements however, have to contend with the uncertainties that inevitably surround many events and circumstances, such as the collectability of doubtful receivables, the probable useful life of plant and equipment and the number of warranty claims that many occur. Such uncertainties are recognised by the disclosure of their nature and extent and by exercise of prudence in the preparation of �nancial statements. Prudence is the inclusion of a degree of caution in the exercise of judgement needed in making the estimates required under condition of uncertainty such that assets and income are not overstated and loss and liability are not understated.



SUMMARY

w Accounting concepts de�ne the assumptions on the basis of which �nancial statements of a business entity are prepared.

The following are the widely accepted accounting concepts:

(a) Entity concept (b) Money measurement concept

(c) Periodicity concept (d) Accrual concept

(e) Matching concept (f ) Going Concern concept

(g) Cost concept (h) Realisation concept

(i) Dual aspect concept (j) Conservatism

(k) Materiality

w Accounting principles are a body of doctrines commonly associated with the theory and procedures of accounting serving as an explanation of current practices and as a guide for selection of conventions or procedures where alternatives exist.”

w Accounting conventions emerge out of accounting practices, commonly known as accounting principles, adopted by various organizations over a period of time.

w There are three fundamental accounting assumptions:

(i) Going Concern (ii) Consistency (iii) Accrual

w Qualitative characteristics are the attributes that make the information provided in �nancial statements useful to users. Understandability, Relevance, Reliability, Comparability, Materiality, Faithful Representation, Substance over Form, Neutrality, Prudence, Full, fair and adequate disclosure and Completeness are the important qualitative characteristics of the �nancial statements.

TEST YOUR KNOWLEDGEMultiple Choice Questions

1. (i) All the following items are classi�ed as fundamental accounting assumptions except

(a) Consistency. (b) Business entity. (c) Going concern.

(ii) Two primary qualitative characteristics of �nancial statements are

(a) Understandability and materiality. (b) Relevance and reliability.(c) Neutrality and understandability.

(iii) Kanika Enterprises follows the written down value method of depreciating machinery year after year due to

(a) Comparability. (b) Convenience. (c) Consistency.



(iv) A purchased a car for ` 5,00,000, making a down payment of ` 1,00,000 and signing a ` 4,00,000 bill payable due in 60 days. As a result of this transaction (a) Total assets increased by ` 5,00,000. (b) Total liabilities increased by ` 4,00,000.(c) Total assets increased by ` 4,00,000 with corresponding increase in liabilities by ` 4,00,000.

(v) Mohan purchased goods for `15,00,000 and sold 4/5th of the goods amounting `18,00,000 and met expenses amounting ` 2,50,000 during the year, 2015. He counted net pro�t as ` 3,50,000. Which of the accounting concept was followed by him?

(a) Entity. (b) Periodicity.

(c) Matching.

(vi) A businessman purchased goods for ̀ 25,00,000 and sold 80% of such goods during the accounting year ended 31st March, 2017. The market value of the remaining goods was ` 4,00,000. He valued the closing Inventory at cost. He violated the concept of

(a) Money measurement. (b) Conservatism.

(c) Cost.

(vii) Capital brought in by the proprietor is an example of

(a) Increase in asset and increase in liability.

(b) Increase in liability and decrease in asset.

(c) Increase in asset and decrease in liability.

2. (i) Assets are held in the business for the purpose of

(a) Resale. (b) Conversion into cash.

(c) Earning revenue.

(ii) Revenue from sale of products, is generally, realized in the period in which

(a) Cash is collected. (b) Sale is made.

(c) Products are manufactured.

(iii) The concept of conservatism when applied to the balance sheet results in

(a) Understatement of assets. (b) Overstatement of assets.

(c) Overstatement of capital.

(iv) Decrease in the amount of trade payables results in

(a) Increase in cash. (b) Decrease in bank over draft account.

(c) Decrease in assets.



(v) The determination of expenses for an accounting period is based on the principle of

(a) Objectivity. (b) Materiality.

(c) Matching.

(vi) Economic life of an enterprise is split into the periodic interval to measure its performance is as per

(a) Entity. (b) Matching.

(c) Periodicity.

3. (i) If an individual asset is increased, there will be a corresponding

(a) Increase of another asset or increase of capital.

(b) Decrease of another asset or increase of liability.

(c) Decrease of speci�c liability or decrease of capital.

(ii) Purchase of machinery for cash

(a) Decreases total assets. (b) Increases total assets.

(c) Retains total assets unchanged.

(iii) Consider the following data pertaining to Alpha Ltd.:

Particulars `

Cost of machinery purchased on 1st April, 2016 10,00,000

Installation charges 1,00,000

Market value as on 31st March, 2017 12,00,000

While �nalizing the annual accounts, if the company values the machinery at ` 12,00,000. Which of the following concepts is violated by the Alpha Ltd.?

(a) Cost. (b) Matching.

(c) Accrual.

Theoretical Questions1. Write short notes on:

(i) Fundamental accounting assumptions. (ii) Periodicity concept.(iii) Accounting conventions.

2. Distinguish between: (i) Money measurement concept and matching concept

(ii) Going concern and cost concept

3. Brie�y explain the qualitative characteristics of the �nancial statements:



ANSWERS / HINTS

Multiple Choice Questions

1.(i) (b) (ii) (b) (iii) (c) (iv) (c) (v) (c) (vi) (b)(vii) (a) 2.(i) (c) (ii) (b) (iii) (a) (iv) (c) (v) (c)(vi) (c) 3.(i) (b) (ii) (c) (iii) (a)

Theoretical Questions

1. (i) Fundamental accounting assumptions: There are three fundamental accounting assumptions: Going Concern; Consistency and Accrual. If nothing has been written about the fundamental accounting assumption in the �nancial statements then it is assumed that they have already been followed in their preparation of �nancial statements.

(ii) Periodicity concept: According to this concept accounts should be prepared after every period & not at the end of the life of the entity. For details, refer para 2.5.

(iii) Accounting conventions: Accounting conventions emerge out of accounting practices, commonly known as accounting principles, adopted by various organizations over a period of time. For details, refer para 2.4.

2. (i) Distinction between Money measurement concept and matching concept

As per Money Measurement concept, only those transactions, which can be measured in terms of money are recorded. Since money is the medium of exchange and the standard of economic value, this concept requires that those transactions alone that are capable of being measured in terms of money be only to be recorded in the books of accounts. Transactions and events that cannot be expressed in terms of money are not recorded in the business books.

In Matching concept, all expenses matched with the revenue of that period should only be taken into consideration. In the �nancial statements of the organization if any revenue is recognized then expenses related to earn that revenue should also be recognized.

(ii) Distinction between Going concern and cost concept

Going Concern Concept

The �nancial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future.

Cost Concept

By this concept, the value of an asset is to be determined on the basis of historical cost, in other words, acquisition cost. For details refer para 2.5.

3. Qualitative characteristics are the attributes that make the information provided in �nancial statements useful to users. For details, refer para 2.7.


unit 2 : accounting concepts, principles and … · accounting information. accounting conventions...

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